Grant Thornton LLP v. Prospect High Income Fund
314 S.W.3d 913, 53 Tex. Sup. Ct. J. 931, 2010 Tex. LEXIS 478 (2010)
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Rule of Law:
An auditor is liable for negligent misrepresentation only to a known party or a limited group of persons for whose benefit and guidance the auditor intends to supply the information or knows the recipient will supply it. Further, claims that a misrepresentation induced an investor to hold securities ("holder claims") are not actionable without a direct communication between the investor and the auditor.
Facts:
- Epic Resorts, LLC, issued high-yield bonds under an Indenture that required it to maintain an $8.45 million escrow account with U.S. Trust to secure semi-annual interest payments to bondholders.
- In March 2000, Epic hired Grant Thornton, LLP, to audit its 1999 financial statements.
- Grant Thornton discovered that Epic had not established the proper escrow account and that the account balance was below the required minimum.
- Despite this, Grant Thornton issued an unqualified audit report in April 2000, which was filed with the SEC, stating that Epic was in compliance with its escrow requirements.
- The Funds, a group of investment entities, purchased Epic bonds. One fund, Cayman, made its first purchase in December 2000, after Grant Thornton's 1999 audit was issued.
- In early 2001, the Funds' senior portfolio manager, Davis Deadman, learned that Epic's primary lender, Prudential, was cutting off its credit facility, which Epic's president described as a critical threat to the company's survival.
- Knowing about the loss of the Prudential credit line, Deadman continued to purchase millions of dollars worth of Epic bonds for the Funds throughout the first half of 2001.
- On June 15, 2001, Epic defaulted on its interest payment to bondholders.
Procedural Posture:
- The Funds sued Grant Thornton in a Texas trial court for claims including fraud and negligent misrepresentation.
- The trial court granted Grant Thornton's motion for summary judgment, dismissing all of the Funds' claims.
- The Funds, as appellants, appealed to the Texas court of appeals, with Grant Thornton as the appellee.
- The court of appeals affirmed the summary judgment in part but reversed as to the negligent misrepresentation and fraud claims, allowing them to proceed to trial.
- Grant Thornton, as petitioner, sought review from the Supreme Court of Texas, which granted the petition.
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Issue:
Does an auditor's duty of care for negligent or fraudulent misrepresentation extend to unknown potential investors who rely on publicly filed audit reports, and can investors assert claims for being induced to hold securities without direct communication from the auditor?
Opinions:
Majority - Chief Justice Jefferson
No. An auditor's duty of care does not extend to unknown potential investors, as they do not constitute the 'limited group' required by the Restatement (Second) of Torts § 552. An investor's reliance on a misrepresentation is not justifiable when the investor is aware of significant 'red flags' indicating the company's financial instability. Finally, 'holder claims' alleging inducement to refrain from selling securities are not cognizable under Texas law without a direct communication between the plaintiff and the defendant. For negligent misrepresentation, the court reaffirmed its adoption of the Restatement § 552, which limits liability to a known party or a limited group for a known purpose. Cayman, as a potential investor on the open market, was not part of such a group. For fraud, which requires a higher 'reason to expect' reliance standard, general industry knowledge that investors rely on audits is insufficient to establish intent. The court found that any reliance by the Funds on the audit reports for purchases made in 2001 was unjustifiable as a matter of law, because the Funds' manager knew Epic had lost its 'lifeblood' credit facility, a 'red flag' that an experienced investor could not ignore. The court also rejected the Funds' 'holder claims' because all alleged misrepresentations were in publicly available documents, and there was no direct communication between the Funds and Grant Thornton.
Analysis:
This decision significantly clarifies and limits the scope of third-party liability for auditors in Texas, reinforcing the state's adherence to the Restatement's restrictive approach over a broader foreseeability standard. By defining 'limited group' narrowly to exclude potential investors on the open market, the court provides substantial protection to accounting firms from suits by unknown plaintiffs. The ruling also sets a high bar for justifiable reliance, particularly for sophisticated investors, by holding that knowledge of other material adverse information can render reliance on an audit report unreasonable. The establishment of a direct communication requirement for 'holder claims' creates a major barrier for plaintiffs in such cases, likely foreclosing many securities fraud lawsuits based on inaction.
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